FHA’s Bleeding Balance Sheet: How it Got There and How to Fix It

The mortgage market is finally showing signs of stabilization, but the Federal Housing Administration is starring down the barrel of $16.3 billion in losses and taxpayers could be on hook for a bailout.

Weighed down by bad loans, the FHA is close to running dry more than $1.1 trillion in mortgages that it currently insures, a new audit of the government agency shows. The FHA had an estimated $2.6 billion in reserves at the end of September, a 45% drop from the same time last year.

“It’s a combination of weak underwriting in the sense that the risk in the mortgages it is insuring is higher than thought,” explained Joseph Gyourko, professor of real estate and chairperson of the real estate department at the Wharton School of the University of Pennsylvania. “The agency originally thought the risk of the borrowers was less than it is and at the same time it ramped up volume and it’s hard to do quality control when increasing business.”

The 78-year-old agency filled the gap in mortgage liquidity after the 2008 financial crisis that froze the credit markets and tightened lending standards, and is a key source of funding for low-income and first-time homeowners. The FHA guarantees loans to private mortgage lenders against default, which makes lenders more likely to issue loans to less creditworthy homeowners.

At a press conference Thursday on Capitol Hill, Rep. Spencer Bachus (R-Ala.), said the FHA “is running out of money for the first time in its history.” The chairman of the House Financial Services Committee predicted that the FHA has a capital shortfall of "several billion dollars.”

The FHA’s cash reserves tumbled to $2.6 billion last year and a 2011 audit showed a 50% chance of the agency requiring a cash injection—something that is now looking like a reality. But the situation might be much worse than what this year’s audit results show.

“The entity is becoming very risky,” said Gyourko. “Its capital reserves are falling so they are getting riskier with insurance guarantees; it has $41 of insurance guarantees per dollar of capital -- that is a 41 to 1 leverage ratio, an increase from 15 to 1.”

How We Got Here

Many private lenders curbed their mortgage practices during the Great Recession causing the FHA’s market share to expand. In 2011, the agency insured one-third of mortgages compared to 5% in 2006.

The FHA is required to keep a 2% capital ratio relative to the total amount of loans that it guarantees, but according to Kevin Cavin, mortgage strategist at Stern Agee, it’s been well below that requirement for more than three years.

“The agency originally thought the risk of the borrowers was less than it is and at the same time it ramped up volume and it’s hard to do quality control when increasing business.”

- Joseph Gyourko, professor of real estate and chairperson of the real estate department at the Wharton School of the University of Pennsylvania

“The FHA didn’t do a lot of business in some of the worse times during the housing bubble in 2005, 2006, 2007, the subprime markets took away a lot of its market share,” said Robert Van Order, a professor of real estate at George Washington University. “The losses at the FHA are coming from mortgages originated around 2008 and 2009 when the subprime market crashed and there wasn’t much of the low down payment market.”

However, the loans it did backstop from 2005 to 2008 continue to erode the FHA’s bottom line as the mortgage delinquencies continue to plague the market.

Most of the loans that FHA insures are for first-time homebuyers and borrowers that put very little money down. The loan-to-value ratios are already very high -- FHA insures loans that have an LTV ratio as high as 96.5, according to Cavin. More seasoned loans, the loans that are currently defaulting, were originated at the peak of the housing boom in 2006 and 2007 and now that those home prices are dramatically lower, with some having a current loan- to-value ratio is north of 100. In other words, a lot of the borrowers are underwater.

The FHA increased market share in the low down payment market has played a role in its bleeding balance sheet. “In 2008 the FHA made less than 5% of the low down payment market, now its share is about 25-30%,” said Van Order.

Where We Go From Here

The decision over whether the FHA will need a cash injection from the Treasury Department won't be made until February, when the White House releases its budget, but bailouts to government-backed housing agencies are nothing new: Mortgage giants Fannie Mae and Freddie Mac have received $137 billion from taxpayers.

A bailout tab with that many zeros can be hard to swallow, but it’s not something that is going to impact the market, said Gyourko. “There will be no effect on existing borrowers; a bailout won’t cause a financial crisis. This report says there’s a negative economic value to the insurance fund, but it’s not a liquidity crisis like Lehman. This is an arm of the government, the losses will be paid off, there will be no financial crisis.”

To help offset its rising losses, the FHA has increased insurance premiums 70 basis points since October 2010, according to Cavin. “It started raising insurance premiums in October of 2010 and in April 2011 they increased by another 25 basis points and then to pay for the temporary payroll tax cut it tacked on another 10 basis points.”

He expects the agency to continue to raise mortgage premiums to more quickly replenish its reserve funds. “Primary mortgage rates are at an all-time low so it can still increase insurance fees and have exceptionally-low primary mortgage rates. Anything else that remains below or around 4% is still astoundingly low.”

The agency is counting on the less-risky securitized loans it made after 2009 to help boost its balance sheet. “The loans from 2010 and 2011 are expected to do reasonably well because the lenders’ credit scores have been better and the housing market is picking up and we’ve seen an increase in prices.”

The FHA said it expects the next years to be more stable and help its cash flow, but Gyourko isn’t convinced. “If you read the fine print, they think the next seven years will be worth $65 billion, so the FHA grows itself out for the problem, but in the last four years, the agency overestimated the value of next year. It’s a highly leveraged operation and they don’t have a good track record.”

Whether it gets a cash infusion from Treasury or not, Van Order said the biggest mistake the agency can make at this point is to continue to look back.

“Business going forward should be done in the best way for this market and environment; it shouldn’t be trying to make up for past losses. The danger here is that you make business mistakes when trying to make up for the past. If Congress needs to inject funds that’s fine -- FHA just needs to be careful about messing up their future mission by trying to make up for past problems.”